No, Dr. Krugman, a Treasury Crash Would Be Bad For the Economy

We shouldn't be reassured that our prosperity's backstop is a printing press.

Ever since the federal government and Federal Reserve’s unprecedented responses to the financial crisis, hard-money types such as Peter Schiff (and less famously, me) have warned Americans to prepare for sharply rising price inflation and interest rates. Keynesians such as Paul Krugman dismissed such fears with the term “invisible bond vigilantes,” and understandably have been pointing to the record-low yields on Treasury securities as proof that the “inflationistas” (another derogatory term) are crazy.

Thus far the debate had been at a standstill: The hard-money types could claim that the dollar and Treasuries were in unsustainable “bubbles,” just as the housing market had been. Peter Schiff was famously laughed at by the pundits in 2006 for warning of a coming crash, and only time will tell if he has also been right about the stimulus package and various rounds of quantitative easing.

However, in a November 9 blog post Paul Krugman took matters even further. He argued that even if the hard-money types were correct, and investors around the world suddenly doubted the ability of the US government to repay its debts…that this would help the US economy. In a moment I’ll walk through Krugman’s extended argument (he dubs it “wonkish”) and show where he goes wrong in reaching such an absurd conclusion. But to reassure the reader that this really is what Krugman is saying, let me quote from a post three days later, in which Krugman responds to a correspondent who (understandably) couldn’t believe the Nobel laureate actually meant what he had written:

A skeptical correspondent asks whether I really truly believe what I’m saying in my post about how an attack by the bond vigilantes is actually expansionary when you have your own floating currency. How does this jibe with the experience of the Asian financial crisis of the 1980s, he asks? And do I really believe that Japan would be better off if markets became less confident in the value of its bonds?

Good questions — but ones that I and others have already answered.

On financial crises past: the key question is whether you have large debt denominated in foreign currency…

The point, of course, is that America doesn’t have a lot of foreign-currency debt. Neither does Japan — which is why I would say yes, reduced confidence in Japanese bonds would actually help their economy. Right now, as I’ve written in the past, the collision of deflation with the zero lower bound means that Japan actually offers investors a higher real interest rate than they can get in other advanced countries. The result is a strong yen that is really hurting Japanese manufacturing. Some loss of faith in those Japanese bonds, whether default risk or fear of higher inflation, would be a blessing. [Bold added.]

So we see that I’m not setting up a straw man here—Krugman is saying (a) right-wingers are nuts for worrying that worldwide investors will lose faith in the dollar/Treasury bonds, since that isn’t going to happen, but (b) right-wingers are doubly nuts because even if it did happen, this loss of faith in dollar-denominated assets would be a good thing for the American economy.

In the “wonkish” link from his blog post, Krugman explains the backdrop for the simple model he is about to create:

We know what a loss of faith in Greek bonds looked like: interest rates soared, with negative consequences for the Greek economy. But Greece didn’t have its own currency, and therefore didn’t have its own monetary policy or its own exchange rate. We do. So what would an attack by invisible bond vigilantes look like for the United States… ?

Krugman then runs through a derivation of his final equation, showing how the interest rate (set by the Fed) can influence domestic demand and also net exports. We don’t need to run through the math, because Krugman conveniently spells out how the rabbit got into the hat:

[W]hat happens if there’s a loss of confidence, causing the risk premium [on US government debt] to rise? The answer is that the currency depreciates for any given domestic interest rate, increasing demand…That is, the effect on the economy is expansionary.

Think about is this way: with the Fed setting interest rates, any loss of confidence in US bonds would cause not a rise in rates but a fall in the dollar—and a fall in the dollar would be a good thing, helping make US industry more competitive.

And there you have it: The reason a sudden loss of investor confidence in government debt was earth-shattering for Greece, but would (allegedly) be good for the US, is that Greece didn’t have recourse to a printing press. Therefore its nominal interest rates went way up, because the ECB refused to soak up an unlimited amount of Greek debt on its balance sheet.

In contrast, Krugman claims that the Fed always has the power to keep interest rates on Treasury debt whatever Bernanke wants them to be. This is because there are no constraints on the Fed from creating more dollars out of thin air, and using them to buy Uncle Sam’s debt, until the yields on that debt hit their target value.

Now the interesting thing about Krugman’s wonkish, 6-page exposition is that he doesn’t qualify it at all. He doesn’t say, “This all assumes we’re in a liquidity trap.” In fact, at the beginning he makes an open-ended statement that even though investors don’t currently worry about a US government default on its bonds, “it is indeed conceivable that international investors at some point might become less sanguine about US debt.”

Such a broad application of Krugman’s result is clearly wrong. To say that a country with its own currency can just print money and keep nominal interest rates at whatever it likes, is to ignore the elephant of the room that a depreciating currency is a euphemism for rising domestic prices, i.e. what most people mean by “inflation.” Thus the problem of spiking interest rates is simply “solved” by giving Americans spiking prices.

This isn’t even an “Austrian” point; I can find a Keynesian blogger who made the point quite nicely last year:

So suppose that we eventually go back to a situation in which interest rates are positive….with the government still running deficits of more than $1 trillion a year, say around $100 billion a month. And now suppose that for whatever reason, we’re suddenly faced with a strike of bond buyers — nobody is willing to buy U.S. debt except at exorbitant rates.

So then what? The Fed could directly finance the government by buying debt, or it could launder the process by having banks buy debt and then sell that debt via open-market operations; either way, the government would in effect be financing itself through creation of base money. So? …

Does this mean 400 percent inflation? No, it means more — because people would find ways to avoid holding green pieces of paper, raising prices still further.

I could go on, but you get the point: once we’re no longer in a liquidity trap, running large deficits without access to bond markets is a recipe for very high inflation, perhaps even hyperinflation…

At this point I have to say that I DON’T EXPECT THIS TO HAPPEN — America is a very long way from losing access to bond markets, and in any case we’re still in liquidity trap territory and likely to stay there for a while. But the idea that deficits can never matter, that our possession of an independent national currency makes the whole issue go away, is something I just don’t understand.

In closing, let me plug one last hole: Krugman would no doubt defend his two posts by saying that we are currently in a liquidity trap, and that even though he didn’t mention the caveat in his “wonkish” discussion, it should have been assumed he meant a strike by bond investors would only be helpful in that case. Once we’re out of the liquidity trap, then sanity returns to the world, and right-wingers are indeed justified in saying it would hurt for the Treasury market to crash.

Yet hang on a second: Krugman defines a liquidity trap as a situation where the Fed has pushed interest rates down to zero, without fixing the economy. So what Krugman is saying is that if investors suddenly stopped wanting to buy US bonds, but the yield on them remained at 0 percent, then this would be a good thing. However, once interest rates became positive again, then the bond strike could lead to hyperinflation.

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12 Responses to No, Dr. Krugman, a Treasury Crash Would Be Bad For the Economy

Mr. Murphy: you rephrase Mr. Krugman’s statements in the following way: “The reason a sudden loss of investor confidence in government debt was earth-shattering for Greece, but would (allegedly) be good for the US, is that Greece didn’t have recourse to a printing press.”

If I have read Mr. Krugman correctly, his argument why such a situation would be good for the US is the depreciation of the dollar, with a resulting increase in competitiveness and surging exports.

This is a consequence of the US having its own currency, but as such has nothing to do with the US operating the printing press, even though having your own currency meaning you have your own printing press.

If I am correct, your representation of Mr. Krugman’s remarks is mistaken.

I’ve never understood the argument that devaluing the dollar makes U.S. industry more competitive.

Let’s assume we’re in a one-country world, where the only currency is the dollar; and furthermore, let’s assume we’re not in a recession. I assume devaluing the currency would not make the economy better off, right? We’d just see prices rise.

Now, even though we’re in a multi-country world with many currencies, doesn’t the same truth apply? Say we look at a country we export to, and its currency is yen. If we devalue our currency, in effect all those holding yen now hold more U.S. dollars. But if they choose to spend that on U.S. exports, then won’t the price of U.S. exports rise, just as surely as prices rise in the one-currency example? Won’t the real price of U.S. exports remain unchanged?

One way to comprehend Krugman’s pedantic but mystical positions on both sides of many issues is to assume that he still takes significant quantities of LSD.

My knowledge of economics is probably the equivalent of 2nd semester understanding. However it seems to me that in a situation where investors are loathe to buy U.S. bonds, then that would remove a source of cash from Congress to redistribute, and otherwise spend on unconstitutional projects.

The recent figure of 43%, representing the amount of spending which has been borrowed for that purpose by Congress, means that without that source of money the government would have to live more within its means. That is to say on taxes alone.

There is probably a big flaw in that line of thinking, for example what shape would our economy be in by the time U.S. bonds are completely shunned by investors; but otherwise what would be the downside? Would someone provide some enlightenment here?

I would hazard that Krugman has changed his views. It appears that the later version reflects acceptance of Modern Money Theory, whereas the earlier version outlined his reasons for doubting it. I’m no expert, by any means. But having followed his debates with MMT a bit, this seems a plausible interpretation to me.

“Thus far the debate had been at a standstill: The hard-money types could claim that the dollar and Treasuries were in unsustainable “bubbles,” just as the housing market had been. Peter Schiff was famously laughed at by the pundits in 2006 for warning of a coming crash, and only time will tell if he has also been right about the stimulus package and various rounds of quantitative easing.”

This is simply a lie; there have been repeated claims of inflation/hyperinflation ‘just around the corner’, which have failed.

Saying that the prognosticated hyper-inflation is still possibly just over the horizon and therefore is not something the hard money types can reasonably expect to be pilloried for is a little self-serving, don’t you think? When the first mass batches of money supply expansion occurred the Austrian set didn’t just predict inflation, they were predicting hyperinflation, dogs and cats living together inflation. Back-pedaling now into a defense of “rising inflation over an indeterminate long term” is reasonable, but it still doesn’t excuse the earlier fear-mongering. I mean, the Fed is aware of the future threat to interest rates, even among the dovish members. It’s worth questioning how and under what circumstances they’ll unwind things, but you really ought to be more comfortable with owning the idea that the predicted hyper-inflation was supposed to be NOW (actually “then”), and that was clearly wrong.

“Back-pedaling now into a defense of “rising inflation over an indeterminate long term” is reasonable,…”

The big thing is that the Fed is quite well equipped to deal with that, both physically and intellectually. Dealing with a slo-mo increase in inflation would be like the USAF swatting the Iraqi air force out of the sky in 2003.

So the Austrian ‘doctor’ has retreated from warning of a sudden disaster striking before we can react to a moderate problem which migh arise over several years (and that’s if and when the economy picks up).

Oh, and if reduced confidence in America’s ability to pay it’s debts would be good for the economy, I think it won’t be difficult to accomplish if Obama just has the *stones* to push us off the fiscal cliff….

The Fed has now locked itself into permanently near-zero interest rates, another source of economic drag. According to David Ranson, head of research, Wainwright Economics, until interest rates are driven once again by market forces, savers will go on strike and credit will be rationed. The economy’s ability to grow depends in part on credit being allocated to the most productive uses rather than the most politically connected constituencies. Therefore, the investment industry consultancy expects the US economy to continue growing at a rate of only 1 to 2 percent.

We will continue to be able to borrow cheap money until the rest of the worlds major economies (Europe and Asia) scrape themselves out of this depression. When that happens, we are in serious economic trouble.

What a blatant misrepresentation of Krugman.
In one case he is describing the economy with excess capacity and a liquidity trap–interest rates at the zero bound; and in the case described above he says the economy is near full employment.

“The key thing to remember is that current conditions — lots of excess capacity in the economy, and a liquidity trap in which short-term government debt carries a roughly zero interest rate — won’t always prevail. As long as those conditions DO prevail, it doesn’t matter how much the Fed increases the monetary base, and it therefore doesn’t matter how much of the deficit is monetized. But this too shall pass, and when it does, things will be very different.

So suppose that we eventually go back to a situation in which interest rates are positive, so that monetary base and T-bills are once again imperfect substitutes; also, we’re close enough to full employment that rapid economic expansion will once again lead to inflation. The last time we were in that situation, the monetary base was around $800 billion.”